In praise of default

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For a huge number of borrowers, be they U.S. homeowners or the sovereign nation of Greece, a default or radical rescheduling of debt might just be the best, most practicable option.

More to the point, default in many of these situations may be not just in the best interests of the debtor but of the economy as a whole.

First, homeowners. Something approaching 50 percent of U.S. mortgage-holders are underwater, meaning the value of the property is less than the value of the mortgage. If a second leg down in housing is under way, that figure will get much higher and the distance to the surface much longer.

It is an axiom of mortgage lending that it is usually far better for the lender to modify, or to cut the principal or repayments, than to suffer the expense of a default. Yet, what few modifications are being done are usually not nearly generous enough to give the borrower an honest economic interest in sticking with the loan.

Many of these borrowers would themselves be better off with a default; better off not overpaying for an asset rather than renting more cheaply, better off because they are not in a stable enough situation for homeownership and better off because it would leave them free to pursue jobs and opportunities elsewhere.

As for the threat of a ruined credit history, you could argue that many of these people’s long-term economic outcomes would improve if they were denied access to credit for a period of years.

The housing bubble was a massive, historic misallocation of capital. Wanting borrowers to keep paying over the odds for an asset, housing, which should be allowed to fall in price is to want to keep misallocating that capital. Rather than keeping house prices high and mortgage portfolios sound, the money that might go to repayments and interests would instead go to either consumption or investment in some other more rewarding area.

There are good reasons for the stigma against default; societies in which people can be counted on to honor their contracts generally produce better, fairer outcomes and are vastly more efficient.

Some will argue that if there are a lot of strategic defaults — defaults undertaken not just because a borrower can’t pay but because it is in their best interest not to pay — loans will become harder to get and more expensive.

Absolutely, and a good thing too, for banks and borrowers. Let the bad lenders take their losses and, if need be, fail.

THE DRUGS DON’T WORK
For nations, default too, in some form, can be the best option. For Greece, and arguably for others, the austerity that many believe is required to make good the debts will put their populations through crushing recession. What’s more, the suffering may well be in vain for, as the austerity kills growth, ability to repay will diminish further.

Look at Ireland, whose austerity program seems to have convinced capital markets that it is a worse rather than better risk.

Speaking about the U.S. debt situation at a recent Morningstar conference, fund manager Jeffrey Gundlach of DoubleLine LLC pointed out that U.S. debt was now 353 percent of gross domestic product, or about 20 percent more than in 1933. For more, click here.

He framed the situation well, noting that there were six ways to dig oneself out of a debt hole.

The first, growth, does not seem to be happening, at least in part because of the dead weight of debt and the lousy way it was allocated.

We are at the limits of the second, lower interest rates, so not much to hope for there.

A transfer payment from outside, the third, might work for Greece if Germany obliges, but is not a scalable solution.

Increasing taxes or cutting spending, Gundlach’s fourth option, are both politically difficult and could cause a downward spiral.

We’ve already printed money, the fifth option, and in my opinion may well print a whole lot more.

Option six is default, and Gundlach predicated some form of “polite default” from the United States either on entitlements or debts.

That I am not sure about, but what is clear is that the United States, because it did not want to sort out its banks properly, took on what may prove to be an unsustainable debt load in order to keep the collateral underlying the system afloat.

Default, like pain, is a very useful signal that something is not right. If you mask it or make it too difficult to register you will carry on doing the things that are damaging.

In the end the banking and financial system is there to support the economy and the people who live in it, not the other way around.

A truly excellent column. You’ve said something important here: “societies in which people can be counted on to honor their contracts generally produce better, fairer outcomes,” but I think you left out the key words: “and institutions.” Our challenge in the US today is that our major institutions, both corporate and government, have for the past few decades lied with absolute impunity. GAAP has been turned into an utter joke, and is today a means for corporations deliberately to lie about their financial standing. Much of the derivatives-driven financial growth of the past 15 years appears to have come about through “spin” or simply outright fraud.

All of this shading of the truth, spin, or plain lying has had the effect of masking the real pain underlying America’s economic decline. While partisans will readily blame the sitting president or whoever else isn’t on their team, the reality is that we’ve built this culture of deceit and dishonesty over the past 30 years. Until we begin unwinding this culture of deception, we have precious little hope, in my view, of dealing forthrightly with the economic mess to which we have all contributed, and in which we ALL find ourselves.

well, in case of private investors or homeowners this may be the right option, but in case of sovereign states, a default may actually be better in the-very-long term, but for 5-7 years the whole population of the country will be thrown to the lions! I mean, extreme poverty, huge unemployment, a diplomatic fiasco in any foreign affairs it may have and a precedent that will remove any serious foreign investment out of the country for many years-and when I mean serious foreign investment, I don’t mean corporations buying a states property for a dime…

Hey- the whole population of some eastern european countries has been repeatedly thrown to the lions, even WITHOUT any defaults on our part! I am of the opinion that this globalization theory doesn’t really work to the advantage of the masses…Nothing new under the sun – did mercantilism benefit anyone byt the rich anyway? or Feudalism? I think Globalizaiton is the new form of Feudalism…Correct me if you can! =)

Whatever is done, has to be done carefully. You cannot fund corporate welfare and let the older people starve. People still require services such as health care, but businesses being given tax breaks for making bad decisions is not smart government. I think that the housing bubble will see many more defaults, and I also think that we will see at least 5 more years of depression.

BRILLIANT!! James for President!! The reason that the current economic crisis will continue and will get a LOT worse is very SIMPLE if we look at the cause.

How did it happen? Unqualified people were allowed by law to acquire debt (mortgages) which they could not service. Thats it, period – nothing more or less. False income declarations and false debt/equity declarations allowed the asset acquisition (real estate) to be bid up beyond its true value, and when the debt could not be serviced, default occurred.

Trying to maintain possession of an overvalued asset acquired by unqualified owners is the same for a house, car, or that flat screen TV when payments aren’t made — the item is re-possessed and offered back to the marketplace where the true price can be established by auction.

The reason that the economic crisis will get a LOT worse, is that the fundamental cause has not been fixed. Home ownership MUST require: 1) income tax documentation used to prove income. 2) a 10-15% unencumbered cash deposit 3) a maximum 50% debt service ratio. Those simple changes would solve the problem. Canada, which has similar requirements has seen NO underwater problem. In contrast, our gutless politicians are wasting billions with convoluted foolish schemes which put the entire country “underwater” with a crushing national debt.

Sovereign default? Also the best solution! What most people DO NOT understand is that the government has NO money — that is, none, nothing, nada! It only has YOUR money and the governments only function is to reallocate it. Its an important thing to understand.

What has happened over time is that government (being politicians and their bureaucracy minions) spend money with reckless abandon and no respect for how hard the populous works to earn a living. Those gold-plated pensions and pork-barrel projects were earned for the most part hour by hour, day by day with sweat and hard labor. So now in the crunch, have you heard of ONE politician anywhere in ANY country which has rolled back their pay, or a public service pension by 50% to put it back in line with the private sector? When was the last time you saw an independent efficiency analysis done on ANY public service contract, or ANY bureaucracy or ANY politician? The fact is — NEVER. Let the unsustainable economic cost to society collapse, financed by sovereign debt and taxes, so the people can vote out the insatiable pigs at the trough, and reclaim their country.

A dollar can go to servicing national debt interest or it can go to schools, community safety, and health. Your choice.

No, the government does have money, because in a government of the people, by the people, and for the people, WE are the government, and we have money. Therefore, by definition, the government has money. This “It’s YOUR money” nonsense is intended to fool you into forgetting that in a democracy, YOU ARE the government.

Debt default for burden sharing
The main reason to consider default in debt workout is to ensure burden-sharing between the imprudent over-leveraged borrower and the irresponsable over-extended lender.

The subprime crisis was not caused by permissive laws but by by credit underwriters putting very little of their own and a lot of foolish investors’ money at risk.
It takes two sides to get into hock.

But why let “defaulters” simply walk away from their homes, which would force the banks to “eat” their bad loans that they should never have made in the first place?

Why not collect “defaulters” and put them into public “workhouses” until their debts are paid off? They could be used on public work projects driving down the expenses of state and local governments.

Entrepreneurs would obviously see an opportunity for investment, so it would create jobs from things like constructing the workhouses, to staff to run them — and of course, guards with dogs to keep these “slackers” from running away.

This idea could start a whole new industry and the country as a whole would benefit tremendously.

Great idea, James! Maybe you could suggest it to President Obama as a way to cut our national debt.

Gordon2352, Have you not heard of ex-post-facto? That and indentured servitude are prohibited by the constitution along with slavery.

Your solution sounds more like a debtors prison. Besides, default is exactly what businesses and corporations do. Should businessmen be exempt so they can get rich locking up those who did the very same thing?